What are Financial Statements
Financial statements provide a formal record of the financial activities and position of a business, person, or other entity, serving as a means to communicate financial information to various stakeholders, including investors, creditors, management, and government agencies.
Financial statements are an important tool for understanding the financial health of a business. They can be used to assess the company’s profitability, liquidity, solvency, and financial position
Types of financial statements
Balance sheet: The balance sheet shows a company’s assets, liabilities, and shareholders’ equity at a specific point in time. Assets are things that the company owns, such as cash, inventory, and property. Liabilities are things that the company owes, such as debt and accounts payable. Shareholders’ equity is the difference between assets and liabilities, and it represents the owners’ investment in the company
The income statement shows a company’s revenues and expenses over a period of time, such as a quarter or a year. Revenues are the money that the company earns from selling goods or services. Expenses are the costs that the company incurs in order to generate revenue. The difference between revenues and expenses is net income, which is the company’s profit or loss
Key components include:
- Revenue (Sales)
- Cost of Goods Sold (COGS)
- Gross Profit
- Operating Expenses
- Operating Income (or Earnings Before Interest and Taxes, EBIT)
- Interest Expense
- Income Before Taxes
Statement of cash flows
The statement of cash flows shows a company’s cash inflows and outflows over a period of time. Cash inflows are the money that the company receives, such as from sales, investments, and loans. Cash outflows are the money that the company pays, such as for expenses, taxes, and dividends.
It is divided into three sections:
- Operating Activities: Cash flows from the company’s core business operations, including sales and expenses.
- Investing Activities: Cash flows related to the purchase or sale of long-term assets like property, equipment, and investments.
- Financing Activities: Cash flows related to borrowing, repaying loans, or issuing/reacquiring stock
Statement of Changes in Equity (Statement of Retained Earnings)
The Statement of Changes in Equity, often referred to as the Statement of Retained Earnings in the case of corporations, is a financial statement that provides a comprehensive overview of how a company’s equity evolves and undergoes modifications over a specified period, typically at the end of a fiscal year. Equity represents the residual interest in the assets of the company after deducting its liabilities, and it mainly pertains to shareholders’ ownership interest.
The Statement of Changes in Equity helps investors and other stakeholders track how a company’s financial health, profitability, and ownership structure have evolved over time
Importance of Financial Statements
To assess a company’s financial health
Financial statements can be used to assess a company’s financial health by looking at its profitability, liquidity, and solvency. Profitability is a measure of how much money a company is making. Liquidity is a measure of how easily a company can convert its assets into cash. Solvency is a measure of a company’s ability to meet its long-term financial obligations.
Financial statements, particularly the income statement, enable stakeholders to assess the profitability of a business. It shows the revenues, expenses, and ultimately the net income or loss over a specific period. This information is critical for investors, creditors, and management to gauge how well the business is performing
To make predictions about a company’s future
Financial statements can be used to make predictions about a company’s future. For example, if a company has been profitable for the past several years, it is likely to continue to be profitable in the future. However, if a company has been struggling financially, it may be at risk of bankruptcy.
Financial statements are used by investors, lenders, and creditors to make decisions about whether to invest in, lend money to, or do business with a company. For example, an investor may choose to invest in a company that has a strong balance sheet and a history of profitability. A lender may be more likely to lend money to a company that has a good track record of repaying its debts. And a creditor may be more likely to do business with a company that is financially stable.
Governments and tax authorities use financial statements to enforce tax laws. Accurate financial reporting is essential for calculating tax liabilities and ensuring compliance with tax regulations
Creditors, such as banks and suppliers, use financial statements to evaluate the creditworthiness of a business. This information helps them determine the risk associated with lending money or extending credit to the entity
Financial statements form the basis of financial analysis, providing critical information about a company’s performance and financial status. Understanding these documents is important for investors, creditors, and anyone concerned about the financial health of a company. Stakeholders gain significant insights into a company’s history, current position, and future prospects by thoroughly reviewing the income statement, balance sheet, cash flow statement, and statement of changes in equity.